Rule #1: Phil Town on Investing

GE CEO Buys Stock... So Buy GE, Right?

The other day, Mike left a comment here on the blog about GE. Here's a quote from his comment (taken from Bloomberg):

Last year was “a tough year, and we expect 2009 to be even tougher,” Immelt wrote.

The CEO, while accepting responsibility, made it clear he intends to see GE through the crisis. Today, as GE shares dropped to the lowest price since May 1993, he bought 50,000 shares in a show of confidence.

“The current crisis offers the challenge of our lifetime,” Immelt said. “I’ve told our leaders at GE that if they are frightened by this concept, they shouldn’t be here. But if they’re energized, and desire to play a part in transforming the company for the future, then this is going to be a thrilling time to be a part of GE.” [By Rachel Layne, Bloomberg]

Hey, you gotta like it when a multi-millionaire puts up his own money to buy 50,000 shares.  Now if he mortgaged his house and bought 5,000,000 shares I'd get excited.  And check out the financials on GE, right?  Notice the debt has doubled twice in the last ten years while earnings and sales and book value have doubled once or less.  And it would take about 35 years to pay it off out of cash flow.  Red flag there.  Not to mention a 3% ROIC. 

And what were they doing with the debt?  Over 60% of it went to pay dividends or buy stock.  WHAT???

They were borrowing money to prop up their stock price?  You gotta be kidding!  And worse, like GM, they were borrowing to pay dividends.  That is almost criminal. 

No CEO should pay dividends because investors expect one.  They should pay a dividend because they have cash they can't invest with a high enough return.  Period.  Anything else is semi-fraudulent and certainly misleading.

In other words, GE was either being run into the ground by incompetence or by traitors who were acquiring businesses that didn't pay off.  So traitors or incompetents.  Either way, unless they change management, how is this going to improve?

It's cheap, but it also has almost no equity at all right now.  Debt is 5 times the equity.

Now go play.

Question from a Reader: Equity, Accounts Receivable and Surplus Cash

A few days ago I received the following question from a reader. I consider this a good "Intermediate Accounting" question for Rule #1 investors to look over.  The basic question: does a growing equity number really mean the company is growing surplus cash?

Phil,

Greeting from Shanghai!   Thanks for your book which inspires me a lot!

I am now reading your book the 2nd time.  I am now on Ch9 'Calculate the Sticker Price'.   In the highlighted box on P151, you said 'The growth of the Sticker Price - the value of the business - most closely follows the growth of equity because a growing equity comes from growing surplus cash'.

I am confused.  In my view, increase in equity does not imply increase in surplus cash at all.   For example, a company sold only 1 item of USD10m in a fiscal year and made a profit of USD4m.  Its revenue is USD10m and profit is USD4m.   But its customer failed to pay.   At the year end, the AR increased by USD4m but not the cash.   However, the retained earning still increased by USD4m, and thus the equity increased by USD4m as well.

Please help me to understand.  Thanks in advance.

David

Here is my response to David:

Investing in Trusts

Here's another recent comment from the blog, dated July 22:

I am a real rookie, and novice and have a quick question.

With an income trust (YPO.Un) is distributable cash per share (payments made monthly per share -dividends?) the same thing as earnings per share?

Thanks

Mitch

My answer:

Mitch,

Cash flow (which is what provides the cash for cash per share payments) is not the same as earnings per share. 

Trusts follow the same accounting rules as corporations.  You have to do your homework if you're going after trust income. 

It's entirely possible to provide cash flow without earnings and to have great earnings without cash flow. 

Invest as if you intend to own the entire Trust.  Look at its predictability.  That is what gives it value.  If it was providing $100 of cash flow today but we knew it would only provide $10 a year for the next 10 years, we wouldn't pay the same for it as if it was going to provide $100 a year for the next ten years. 

It's all about being knowledgeable enough to feel that your estimate of future cash flow and/or earnings is conservative.  And then estimating current value based on those numbers, and then buying when you get a margin of safety price below current value. 

If and only if you do this will you both sleep at night and wake up wealthy in a few years.

Buffett and BNI

A few weeks ago, Ven left the following comment:

Phil,

I just read Michael Brush's article "How Buffet is Playing This Market" on MSN. He says that Buffet is investing in BNSF Railway, but according to Investools, the BNI stock is not a bargain. In fact at the present it is at 77.00, with a valuation of 73.77. Of course I know Buffet knows what he is doing, but is this a good investment for me because Warren says it is?

Thanks,
Ven

Ven asks how it is that Buffett could buy BNI in spite of its price being higher than its value. 

Well, we have to ask, what is the value of BNI?  Buffett has been buying it in the high $70s and low $80s.  Is the value really less than the price? 

Free Cash Flow on MSN

Rule #1 Reminder: Where to Find Free Cash Flow Numbers on MSN

Originally published 5/15/07 in the FAQ, as Where do I go to find Free Cash Flow data on MSN?.  This post will help you gather the FCF numbers to input into Excel or the Rule #1 Cash Flow Calculator -- so you can determine how much a company has grown its Free Cash over time.

Here's how to do it:

Let's use WFMI as an example:

Go to MSN.
Enter the stock symbol (WFMI) and hit Return. You get this screen, shown below.  [Click on an image to see it larger in a pop-up window.]

Click on Financial Results > Statements (in the side bar).  You will end up here.

Choose the tab marked "Cash Flow".  You'll end up here.

Free Cash Flow is the cash a business has left over AFTER it subtracts what capital items it needs -- things like manufacturing plants and replacing machinery that broke.

To arrive at Free Cash Flow, you need to subtract Capital Expenditures from Cash from Operating Activities. 

(FCF = Cash from Operating Activities - Capital Expenditures)

For the “Cash from Operating Activities” value, use the appropriate number from the line “Cash from Operating Activities”.  See image below to learn where to find this line of information.

For the “Capital Expenditures” value, click on the blue arrow next to “Capital Expenditures” to expand the section. Underneath it, look for the line labeled “Purchase of Fixed Assets”. 

Use this number, "Purchase of Fixed Assets", as your "Capital Expenditures" number.

You may note there are 5 years of numbers here (as mentioned in the book). Unfortunately, free sites like MSN are only offering 5 Year Data for Cash Flow. To go back further you'll have to either subscribe to a paid research tool or look up past years' statements in the Investor Relations section of the company website.

Stock Splits: How They Work

Rule #1 Reminder: How do stock splits work?

Originally published 6/23/05 as a response to a Homework submitted by a reader.

Stock splits are the same as taking a dollar and splitting it into two fifty cent pieces.  You still have a dollar of value but it's been broken into more easily traded currency.  Stock is split so that it can be more easily bought in blocks of 100 shares by options traders, people doing covered calls and so on.  It is just an accounting process, not a real change in price.

Shortly after the stock split you will see the entire charted history of the company change to reflect the new price per share relationship.  That means that the stock chart which showed the price at $100 in June, will now show it at $50 in June.  Everything else that is calculated on a per share basis like EPS will be recalculated to reflect the new number of shares.  But the actual value of the business stayed the same.

So.  All your calculations that were done on the old EPS of $6 will be redone to reflect the new EPS of $3.  The old Sticker of $100 become $50.  The old MOS of $50 becomes $25.

Make sense?

Phil

Related Posts:

The Stock Split Game (Starbucks)

Forward PE: Why It's Not Important to Rule #1

Once every few weeks, I get an email from a reader wanting to know how to use Forward PE when evaluating a company.  That's why the following post from the Archives is the subject of this week's Rule #1 Reminder.  This post is also helpful to those of you who may need a reminder as to why the Big Five Numbers are an important part of determining Moat.

Rule #1 Reminder:  How Do I Use Forward PE?

First published on 5/22/06 as a Question of the Week.

This week's Question of the Week comes to me from Brad and his dad in Dallas. In a nutshell, they want to know if they can postpone doing the Big 5 Numbers. Read on.

Phil,

My father and I are having a discussion, which by the way, is great that you turned us on to something that we can work together on.

Pop writes:

The success of the Rule #1 method in calculating the present intrinsic value (Sticker) of a stock depends entirely upon its ability to predict the stock's future price per share. Really, only two numbers are needed to do that analytically: (1) future EPS growth and (2) future PE.

Evidently, Mr. Town doesn't trust our ability to accurately predict future EPS growth (else why does he use the analysts' prediction over his own if the analysts' number is lower?) but he has great confidence in predicting future PE (else why does he typically ignore analysts' future PE predictions?).

Answers to Your DNA Questions

Well, I’ve been doing what ever I want these last four weeks.  Pretty much ignoring the market.  I was on Maria Bartiromo’s show a while back and suggested that you mutual fund buyers get out because the big guys were heading for the door.  Hope you did it.

By the way, this is one of the great perks of Rule #1 investing: doing what you want, including hanging out in cash.  You can take time when you want.  Trust me on this: It's worth the trouble learning to invest well to be able to take time with your kids, read a novel, snowboard, fly in friends and family for the holidays.

I spent part of the holidays rehabbing an injury that I got by falling off my horse.  I took Cowboy up a hill and asked him to jump up a couple of feet over embedded railroad ties onto a flat table top landing.  A dog ran under his feet on the landing, Cowboy shied to the right, and I went spinning out of the saddle.  I did manage to stick the landing like some 18 year old gymnast, but the impact cracked my L-3.  Put me in a brace for a while.

I was feeling pretty good a couple of weeks ago and Jackson Hole was getting huge powder dumps every night, so I took off the brace, got out the snowboard and went up in the deep stuff, and it was good.  Real good.  Too good.  I got carried away, popped a small jump on the Jackson Faces, and landed with my right butt cheek on a rock that was about 8 inches under the snow.  Lit me right up, but after x-rays it was nothing a shot of morphine wouldn’t take care of.  But it's still got me limping around, so here I am at home with a sore ass and time on my hands and I just don’t have any excuses left to keep me from answering all those really good questions about Genentech (DNA).  So here we go -- answers to your comments:

A Rule #1 Look at DNA

You know I want you all to invest in businesses you understand.  I'm a river guide.  What I understand well is pretty much limited to burgers and Harleys, but I do like to venture into things that have a lot of potential from time to time.  And I get tips from friends.  It's the tips from friends thing that gets me sometimes.  You know, friends who are insiders someplace or at least they know people.  My kid knows her friend whose mom used to work there.  That sort of thing.  Stuff you can really trust.  Right.  But still.

So here we go on DNA -- Genentech -- which came highly recommended by friends who built a nice life by getting DNA stock before it went public and selling a bit here and there as it went up to $100.  Now it's dropped down to $70, and unless Genetech is about to hit a wall, it's looking pretty much like a very good business that is on sale.

Here's how I looked it over this morning (and I'm using Investools here, just for time's sake):

5 Stocks: A Rule #1 Analysis of Jim Jubak's Picks

One way to learn about investing your own money is to do your own analysis on investing advice from the pros.  It's kind of fun to do a Rule #1 analysis on a list of stocks that some professional has just claimed will be high return investments and find that the results of the analysis show you that the stocks are either highly speculative or way overpriced. 

And it's even more fun when you discover an occasional wonderful business that's on sale.

Jim Jubak writes a column on investing on MSN Money called Jubak's Journal.  Today (Dec. 7) he picks five stocks that should do well as the dollar falls in value against other currencies.  Let's take a look at the five and see if any of them is a great business that's on sale.